Declining-balance depreciation of a $50,000 asset with $6,500 salvage value over 20 years.
'Depreciation' is a term used in
accounting,
economics and
finance with reference to the fact that
assets with finite lives lose value over time. (There is also a separate use in
international finance to refer to a reduction in the
exchange rate of a
currency - see
Depreciation (currency)).
In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an
asset across its useful life, roughly corresponding to normal
wear and tear.
[1] It is of most use when dealing with assets of a short, fixed service life, and which lose value over that life.
Depreciation is an example of applying the
matching principle as per
generally accepted accounting principles. Depreciation in accounting is often mistakenly seen as a basis for recognizing impairment of an asset, but unexpected changes in value, where seen as significant enough to account for, are handled through write-downs or similar techniques which adjust the
book value of the asset to reflect its current value. Therefore, it is important to recognize that depreciation, when used as a technical accounting term, is the allocation of the historical cost of an asset across time periods when the asset is employed to generate revenues. This process of cost allocation has little or no direct relationship to the market value or current selling price of the asset, it is simply the recognition that a portion of the asset's cost--the portion that will never be recuperated through re-sale or disposal of the asset--was "used up" in the generation of revenues for that time period.
The use of depreciation affects the
financial statements and in some countries the taxes of companies and individuals. The recording of depreciation will cause an expense to be recognized, thereby lowering stated profits on the income statement, while the net value of the asset (the portion of the historical cost of the asset that remains to provide future value to the company) will decline on the balance sheet. Depreciation reported for accounting and tax purposes may differ substantially.
Depreciation and its related concept,
amortization (generally, the depreciation of intangible assets), are non-cash expenses. Neither depreciation nor amortization will directly affect the
cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may either not figure in the
cash flow statement, or may be "added back" to
net income (along with other items) to derive the
operating cash flow.
[2] Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce
taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes.
In
economics depreciation is the decrease in the economic
value of the
capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If capital stock is
at the beginning of a period, investment is
and depreciation
, the capital stock at the end of the period,
, is
.
Accounting
A company needs to report depreciation accurately in its
financial statements in order to achieve two main objectives. First, to match its expenses with the income generated by means of those expenses. Second, to ensure that the asset values in the balance sheet are not overstated. An asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.
Depreciation is an estimated or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), and consistently employed. However, there is no expectation that each individual item declines in value by the same amount, primarily because the recognition of depreciation is based upon the allocation of historical costs and not current market prices.
Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.
Recording depreciation
For historical cost purposes, assets are recorded on the balance sheet at their original cost; this is called the historical cost. Historical cost minus all depreciation expenses recognized on the asset since purchase is called the
book value. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Salvage value is the estimated value of the asset at the end of its useful life. In this way, total depreciation for an asset will never exceed the estimated total cash outlay (depreciable basis) for the asset. The exception to this is in many price-regulated industries (public utilities) where salvage is estimated net of the cost of physically removing the asset from service. If the expected cost of removal exceeds the expected raw (or gross) salvage, then the net of the two (called Net Salvage) may be negative. In this case, the depreciation recorded on the regulated books may exceed the depreciable basis. Companies have no obligation to dispose of depreciated assets, of course, and many depreciated assets continue to generate income.
Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in process. Depreciation is recorded as an adjusting journal entry.
A write-down is a form of depreciation that involves a partial write off. Part of the value of the asset is removed from the balance sheet. The reason may be that the book value (accounted value) of the fixed asset has diverged from the market value and causes the company a loss. An example of this would be a revaluation of
goodwill on an
acquisition that went bad.
Methods of depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.
Straight-line depreciation
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "
salvage value" of the asset after the length of time over which it will be used to generate revenues (useful life), and will recognize a portion of that original cost in equal increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a "salvage value" of US$2000, will depreciate at US$3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the cost of the asset (that can never be recuperated through re-sale) divided by number of years of its useful life.
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered a gain and included in the calculation of net income. In addition, this gain would be recognized as income by the tax office (
capital gains). If the sales price is ever less than the book value, the resulting
capital loss is tax deductible.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.
Sinking fund method
A method of depreciation under which the depreciation expense is an amount of an annuity so that the amount of the annuity at the end of the useful life would equal the Acquisition Cost of the asset. Theoretically, the depreciation charge should include interest on accumulated depreciation at the beginning of the period. This method is rarely used in practice.
The sinking fund method allocates more depreciation to the later years.
The depreciation for the first year equals the annual deposit needed for a sinking fund to accumulate at the given rate to an amount that equals the depreciation base.
Then for each consecutive year, the annual depreciation equals the annual sinking fund deposit plus the interest earned on the fund up to that year.
Declining-balance/Reducing balance depreciation
A declining-balance method, also known as the reducing balance method, is a type of
accelerated depreciation because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new. In the U.S., a form of declining-balance depreciation,
MACRS, is used for tax purposes and is based on time.
In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor. The factor is commonly two; this is known as double declining-balance. Each period we calculate depreciation:
:
For the double-declining balance method, using the vehicle example from above, we compute the depreciation after the first year:
:
We subtract $6800 from our previous year's net book value to obtain our new net book value:
. For the second year, we use this new value to calculate depreciation. Notice that it is significantly lower than the first year:
:
This process continues until we reach the salvage value or the end of the asset's useful life. Since declining-balance depreciation doesn't always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life. It should also be noted that the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used.
'Activity depreciation'
Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, we estimate its life in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. We calculate a per-mile depreciation rate: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, we then calculate the depreciation expense by multiplying the rate by the actual activity level.
Sum of years digits depreciation
Sum of Years Digits is a historical depreciation method that results in a more accelerated write off than straight line, but less than declining balance or later methods. Salvage value is counted in the method. There are no property classes of later methods.
★ Given;
★
★ ''N'' = Depreciable life of asset
★
★ ''B'' = Cost basis
★
★ ''S'' = Salvage value
★
★ ''D''(''t'') = Depreciation charge for year ''t''
★
★
★
★
'Example': If an asset costs $1000, has a depreciable life of 5 years and a salvage value of $90, compute its depreciation schedule.
:
| Year | ''D''(''t'') | Sum of ''D''(''t'') | Remaining Book Value |
| 1 | $303 | $303 | $697 |
| 2 | $243 | $546 | $454 |
| 3 | $182 | $728 | $272 |
| 4 | $121 | $849 | $151 |
| 5 | $61 | $910 | $90 |
The equation for year 1 would look like this:
:
Note: Most depreciation schedules round to the nearest dollar.
Units of Production depreciation
Units of Production depreciation is used in the U.S. in cases where MACRS is inappropriate, and the value to depreciate is based in the asset, such as a mine or natural resources. The method calculates the depreciation based on the units of the asset place in service as compared to the total units of the asset.
Units of time depreciation
Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year.
A simple example can be given for construction co, where some equipments are used only for some specific usage. Depending on the number of projects the equipment will be used & depreciation charged accordingly.
Taxes
When a company spends money for a service or anything else that is short-lived, this expenditure is usually immediately
tax deductible in some countries, and the company enjoys an immediate tax benefit.
[3]
However, when a company buys an asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must ''depreciate'' the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years. In the US, the
IRS's
depreciation schedule for any given class of asset is fixed, and is related to typical durability. A computer may depreciate completely over five years; a nonresidential building, usually 39 years. The maximum allowable useful life under US income tax regulations is 40 years. Though the IRS does allow a small choice of permutations for
depreciation life and acceleration, it does not allow a taxpayer to invent any random asset life. Other countries have other systems, many simply eliminate all choice altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower (taxable) net income in a given period (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes;
Section 179 of the Internal Revenue Code allows for this treatment in some circumstances). Technically, these are not considered "tax reductions" but
tax deferrals: lowering taxable income now by increasing expenses should increase future taxable income (and taxes) at a later date.
Economics
In economics, the value of a capital asset is equal to the
present value of the flow of services the asset will generate in future, appropriately adjusted for uncertainty.
Economic depreciation over a given period is the reduction in the remaining value of future services.
Under certain circumstances, such as an unanticipated increase in the price of the services generated by an asset, its value may increase rather than decline. Depreciation is then negative.
National accounts
In
national accounts, depreciation represents the decline in the aggregate
capital stock arising from the use of capital in production, also referred to as
consumption of fixed capital. Hence, depreciation is equal to the difference between aggregate (
gross)
investment and
net investment or between
Gross National Product and
Net National Product. Unlike depreciation in business accounting, depreciation in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits derived from their use.
Further reading
1. Beginner's Guide to Financial Statements by the US Securities and Exchange Commission
2. ISAB standards on the treatment of goodwill and other intangible assets
3. IRS small business tax guide
See also
★
John I. Beggs (1847-1925) - The American
businessman responsible for modern depreciation techniques
★
Amortization
★
Expense
★
Consumption of fixed capital
★
Tax depletion
★
Cost segregation study
★
Deferred tax
External links
★
Depreciation Accelerated depreciation, book vs. tax depreciation, use of estimates, journal entries...
★
Fixed Asset Info Automatic depreciation calculator, tax and other accounting links, depreciation classes, and more...
★
DepreciateEm Online tool for real estate investors, bringing tax reductions through accelerated depreciation
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